Today is the tenth anniversary of the subprime mortgage crisis, which eventually metastasized into the global financial crisis. This crisis began on August 9, 2007 when BNP Paribas had to halt the redemption of funds as a result of a complete evaporation of liquidity in the U.S. subprime mortgages its funds were invested in.
Allow me to translate that into plain English: Bankers knew from their own loan portfolios that their counterparties owned dubious assets that were nearly impossible to value. The ensuing near depression we experienced was the result of a steady contraction of credit. Countrywide Financial and numerous other lenders could no longer obtain financing starting in 2007. Housing values came racing down, and stock prices followed their precipitous descent.
Perhaps, ten years on, we can look back and learn a key lesson from this experience, to wit that there is a difference between a market crash and a market crisis. When a crash occurs, you lose your money. When a crisis occurs, you lose your trust. When markets recover, you regain your money, as market participants indeed have over the past decade. But have we regained our trust? I would say not entirely, which is why a lingering sense of crisis remains.
As details of the crisis gradually became known, we learned that the banking industry had become purveyors of “NINJA loans” for those with no income, no job or no assets; “liar loans” for customers making absurd claims about their qualifications that bankers happily overlooked; and “stretch loans” for those who would need to use more than half their income to pay their mortgages.
Most ordinary people had no clue what was going on at their local banks, though cognoscenti like Warren Buffett had warned as early as 2003 that subprime mortgages were “instruments of mass financial destruction.”
Banks, like the now defunct Washington Mutual, had taken on enormous debt relative to equity. Fears of excessive leverage were dulled by a sense that the government would not let them fail, and were overshadowed by the appetite for enormous annual bonuses.
The market crash that began in 2007 accelerated in 2008 with the collapse of Bear Stearns triggered by near total losses in two hedge funds owning subprime securities. A rapid-fire government-engineered sale of Bear Stearns to JPMorgan (NYSE:JPM) headed off an immediate crisis.
Then San Francisco Fed president Janet Yellen, in a 2009 speech, explained what this process looked like at the level of individual businesses throughout 2007 and 2008:
Once this massive credit crunch hit, it didn’t take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm.”
Credit became unavailable throughout the economy. A full-blown systemic banking crisis was at hand, the root of which was a lack of trust. Banks would not lend to each other. Knowing all too well the dodgy assets on their own books, they feared they would not be repaid.
The key lesson here is that when trust disappears from the marketplace, business withdraws from the marketplace. This idea, that markets are predicated on moral responsibility, was understood by our Founding Fathers. “Avarice, ambition, revenge, or gallantry, would break the strongest cords of our Constitution as a whale goes through a net,” John Adams said. Indeed, we need to restore checks and balances at all levels of our society and economy.
Please share your thoughts in our comments section. Meanwhile, here are other financial advisor-related links:
- Cullen Roche: “Value” and “growth” are Wall Street marketing terms, not marketplace reality.
- Howard Wiener takes a critical view of the recent jobs report.
- James Picerno: Market may be frothy, but recession risk remains low.
- Columbia Threadneedle Investments: The long unwinding road of quantitative easing.
For more content geared to FAs, visit the Financial Advisor Center.